As companies come under the strain from growing pension liabilities, how are they likely to respond? This column looks at hundreds of the largest public companies in the UK and finds that these firms tend to make up their funding shortfalls by paying lower dividends to shareholders, rather than cutting back on investments.

The most recent LCP (2011) European Pensions Briefing reports that the pension deficits of the world’s largest 100 companies had risen to €290 billion at the end of September 2011.1 The latest Purple Book, jointly produced by the UK’s Pension Protection Fund and The Pensions Regulator and focusing on the risks faced by occupational defined benefit pension schemes, reports that there were 5,450 schemes in deficit (85% of the total) in December 2011, and their aggregate funding deficit on a Pension Protection Fund liabilities (section 179) valuation at 31 March 2011 was £78.3 billion, or £470.7 billion on a full buy-out basis.2 Yermo and Severinson (2010) compare the regulatory frameworks for pension funds across OECD countries and examine how these different systems have responded to the financial crisis. In the UK, the Pensions Act 2004 empowers The Pensions Regulator to intervene when pension schemes are in deficit and require sponsoring companies to fully fund their pension liabilities. At a time of low economic growth and fiscal austerity, it is interesting to speculate on the effectiveness of these regulations and how companies respond to such obligations. Potentially, companies could defer funding their liabilities, or alternatively they might reduce wages and other costs, dividends, and investments. In this article, we explore these issues, drawing on recent research that provides evidence on corporate responses to pension deficits which require mandatory top-up funding and investigating their effects on company behaviour.

In general, companies’ corporate expenditures (dividends and investments) are constrained by a sources and uses of funds equation that says the sources of funds (after-tax profits, new equity issues and new debt issues) must equal the uses of funds (dividends and investments). Since pension contributions are a labour cost, any increase in pension contributions will reduce a firm’s profits. In perfect markets, investments are determined by a capital budgeting rule, and firms issue new equity or debt to fund any shortfall from retained profits; dividends are then paid out as a residual. However, empirical work has found that internal cash flows affect both investments and dividends.

There are two alternative theories as to why balance sheet structures might matter in investment decisions (Myers 2001) – the trade-off theory (trading off tax-deductible debt interest payments and costs of financial distress) and the pecking order theory (costly information asymmetries means investments are funded by first using internal resources, then debt and, as a final resort, equity). Although some authors (Shyam-Sunder and Myers 1999) argue that empirically the pecking order hypothesis outperforms the trade-off hypothesis, other work (Rajan and Zingales 1995) finds support for both theories, since large companies tend to have higher debt ratios, but more profitable companies have lower debt ratios. Tests of the pecking order versus trade-off theories have concluded that the pecking order theory applies to large mature firms, and the trade-off theory to small, young growth firms (Fama and French 2002, Frank and Goyal 2009). The related financial constraints literature has debated the interpretation of investment-cash flow sensitivities (Fazzari, Hubbard and Peterson 1988, Kaplan and Zingales 2000).

Webb (2007) has argued that agency conflicts between shareholders and pension plan holders will affect both dividend and investment policies, since firms with large pension deficits who are acting in the interests of their shareholders will be more inclined to pay out cash flows and to either underinvest (due to a debt-like overhang of pension liabilities) or invest in risky projects (due to risk-shifting). Cocoa and Volpin (2007) discover some evidence of risk-shifting in a sample of UK firms, but in contrast, Rauh (2009) finds that US firms with poorly funded pension plans, and thus the greatest incentives to risk shift, are more likely to invest in safe assets such as government bonds and cash. He suggests that risk-shifting is dominated by risk-management incentives to avoid costly financial distress. Franzoni (2009) examines the stock price reaction to mandatory pension contributions, and finds a larger fall in stock prices for those firms that are a priori financially constrained. Overall, he reports that overinvestment is the more significant problem for large firms, but underinvestment is more characteristic of smaller firms.

Following Benito and Young (2007), Bunn and Trivedi (2005) apply a dynamic panel data model to a firm’s dividend and investment decisions and estimate the effect of pension contributions on corporate expenditures. They find that pension contributions are negatively and significantly related to both dividends and investment, although the evidence is weaker on investment. However, their sample only extends to 2002 and does not include information on pension funding status – defined as the percentage deficit of the pension scheme – since companies have only been required to reveal this information since the introduction of accounting standard FRS17 in 2001. In the absence of funding status details it is not possible to separate out firms with defined contribution (DC) pension schemes; yet such firms are not required to make mandatory pension contributions.

Rauh (2006) cautions whether a negative relationship between investment and pension contributions should be interpreted as evidence for financial constraints, since this correlation could also imply limited investment opportunities with firms making voluntary pension contributions instead. Using a sample of 1,551 US firms over the period 1990-8, Rauh (2006) allows for the endogeneity between funding status and investment by separating firm cash flows into pension- and non-pension-related components, and finds that the negative relation between capital expenditure and pension contributions still holds even when controlling for the correlations between the pension funding status and the firm’s unobserved investment opportunities.

In recent research together with Weixi Liu, I explore these issues further by examining the effect of a company’s mandatory pension contributions on its dividend payments and investment spending, using a panel of 180 FTSE350 listed firms companies with at least one defined benefit pension scheme over the period 2000-7 (Weixi and Tonks 2012). This dataset allows us to assess the impact of funding rules under the Minimum Funding Requirement (MFR) over the period 2000-4, but also whether the new funding requirements introduced under the Pensions Act 2004 have had any effects on firms’ pension contributions and, accordingly, their corporate expenditure decisions over the period 2005-7.

We find that the mean ratio of pension deficits to assets in our sample is 8.6%, and 847 of the 935 firm-year observations over the period are underfunded, representing 90% of all sample firms. These figures illustrate the severe shortfall within UK occupational pension schemes after the introduction of FRS17 in 2001. We find there is a strong negative relationship between a firm’s dividend payments and its mandatory pension contributions, even after controlling for the endogeneity of pension funding status on dividends and investments. The effect of pension contributions on investments is weaker than the evidence for US companies, suggesting that pension regulations in the UK allow firms sufficient discretion to maintain investment spending, and that in the UK the response of balance sheet adjustments to financial pressures takes place through dividends rather than real investments.

Under the Minimum Funding Requirement, pension contributions for underfunded firms were smoothed over a number of years, but after 2005, the MFR was replaced with firm-specific funding requirements – allowing firms to focus on developing optimal funding plans appropriate to the circumstances of the scheme – and The Pensions Regulator, with the powers to require companies to fund their pension liabilities. Dividend and investment sensitivities to pension contributions are more pronounced in and after 2005, indicating that the regulations in the Pensions Act 2004 have had a significant effect on corporate expenditures.

These results show that the channel through which companies with large pension deficits make up their funding shortfalls is paying lower dividends to shareholders, rather than cutting back on investments. The implication is that shareholders in a company with a pension deficit should anticipate that future dividends are likely to be reduced and this may have implications for share prices.

Do shareholders recognise that pension deficits need to be funded, and work out the implications for company market values? Early work (Feldstein and Seligman 1981, and Bulow et al 1987) found that share prices fully reflect the value of unfunded pension obligations, but more recently Coronado and Sharpe (2003) provide evidence of overvaluation of defined benefit firms by looking at different measures of underlying values of net pension obligations. Using US data for the previous 20 years, Franzoni and Marin (2006) examine the decile portfolio of the most underfunded companies and find they earn lower subsequent returns than companies with healthier pension schemes. They attribute this anomaly to a manifestation of the price adjustment following the negative earnings surprise to the market that is a consequence of the company being required to fund the pension deficit. In earlier research (Liu and Tonks 2010), we find no such pattern of negative returns for a sample of UK FTSE350 firms with severely underfunded pension schemes over the period 2000-5. The implication is that in the UK these funding deficits were already incorporated into stock prices.

1 The funding situation deteriorated further throughout the following six months, following falls in equity values and bond yields. According to an LCP update, the deficit had increased to €300 billion by end-March 2012.
2 Pension Protection Fund/Pension Regulator (2012) Table 4.2 page 39, and Chart 5.6 page 51. The Purple Book is based on a comprehensive dataset of 6,432 schemes in the UK, and reports the extent of scheme underfunding, and the risks of the sponsoring employer becoming insolvent. Pension Protection Fund-liabilities are the value of pension liabilities if the Pension Protection Fund (equivalent to the US’s Pension Benefit Guaranty Corporation) took over responsibility for the pension, and includes caps on pension payments; full buy-out liabilities are calculated without any of the Pension Protection Fund caps. The PPF 7800 index of funding deficits was £206 billion at 31 March 2012